EDHECinfra

The growth of #fake_infa: a fallacy of composition

July 10, 2017

For the past fifteen years, infrastructure investment has been the preserve of large sophisticated investors but is now rapidly becoming more mainstream and asset owners of all sizes are considering investing in infrastructure equity or debt.

Originally confined to private equity or debt strategies, the label “infrastructure” can now be found on numerous financial products.

In this short note, we argue that not all products labelled “infrastructure” are adding value to the portfolio of an institutional investor.

The investment beliefs associated with infrastructure are rooted in a strong economic narrative, as well as recent public policy developments.

But this intuitive story is being used to sell different things. In particular, the fast growing “listed infrastructure” sector is shown by peer-reviewed academic research to offer zero additional value to an institutional portfolio.

We call this #fake_infra.

The Appeal of Infrastructure Investment

The value proposition of infrastructure investment is always framed in the same terms:

Infrastructure delivers essential services to the economy on a quasi-monopolistic basis, implying stable demand and a low-price elasticity of demand. This potential pricing power is often associated with inflation hedging characteristics;
Also as a result of its pricing power, infrastructure is also expected to exhibit “attractive” risk-adjusted returns (i.e. a risk-free monopoly rent);

Low business risk is expected to generate stable cash flows and by extension low return volatility and limited draw-down and value-at-risk;

Likewise, low correlation with the business cycle suggests the potential to improve portfolio diversification.
The infrastructure sector outlook is also expected to be bright, in a context where most major OECD economies have adopted national infrastructure plans designed to revamp ageing public infrastructure and kick-start the economy.

This investment narrative springs from a series of intuitions about what infrastructure businesses are like or for, but until recently, empirical evidence confirming this view was not forthcoming.

Since 2017, the investment characteristics of private infrastructure debt and equity have now been documented by EDHECinfra , but several years before the first private infrastructure market benchmarks could be released, a strand of financial products emerged and has been growing rapidly ever since in the public equity space and known as “listed infrastructure.”

The growth of #fake_infra

In a 1977 Fortune column, Warren Buffet famously imagines the ideal long-term asset: “an inflation-linked bond with rising coupons”. His point being of course that there is no such thing.

Still, “Listed infrastructure” is often presented as if it was that very silver bullet i.e. an investment that can do everything an investor might want from delivering a high Sharpe ratio to hedging inflation, diversifying portfolio risk and protecting against market downturns, all the while being liquid, transparent and with a documented track record.

It’s a great story. And listed infrastructure products have mushroomed on the back of the new-found interest of medium to small-sized investors for infrastructure investment.

Combining all listed products referring to listed infrastructure, mutual funds and exchange traded funds, we tallied more than USD50bn of assets under management allocated to these strategies at the end of 2016.

The listed infrastructure sector is becoming more well-known, with its own Morningstar category and industrial lobby group (the Global Listed Infrastructure Organisation).

But listed fake infrastructure is #fake_infra.

What EDHEC Research shows

In a recent research paper (“Searching for a listed infrastructure asset class”) published in a peer-reviewed academic finance journal in April 2017, we show that :

21 different indices of listed infrastructure stocks have equivalent or higher risk than the market index, with which they are all highly correlated;

Adding any of these 21 proxies to an investor’s asset mix has no discernible effect on their mean-variance efficient frontier in global and U.S. equity markets over the past 15 years;

Listed infrastructure is fully spanned by existing asset classes or risk factors i.e. it is 100% replicable using assets that investors already have.

Arguing that listed infrastructure somehow transforms the infrastructure investment narrative identified above into a well-identified class of public stocks that expands the investment universe thus fails to pass 189 tests of statistical significance.

A second EDHEC paper, decomposes the returns of listed infrastructure indices into the standard factor tilts known as the Fama-French factors.

It shows that the returns of global and regional listed infrastructure indices are fully explained by a traditional Fama-French multi-factor model, confirming that they are replicable using non-infrastructure stocks;

The paper’s results leave no room for an extra listed infrastructure effect or alpha: the regression intercept is always zero

Two very different approaches (mean-variance spanning, multi-factor modelling) concur to conclude that there is no such thing as a listed infrastructure asset class.

Blanc-Brude et. al. (2016) show that the cash flows of private infrastructure firms are less volatile than in rest of the economy. But dividend payouts are more volatile. Blanc-Brude (2013) shows that dividend payouts in listed infrastructure firms are more volatile than the market average

“Predictable returns often linked to inflation”

Not verified

Rodel and Rothballer (2012) show that listed infrastructure does not offer better inflation hedging properties than the stock market in general.

The infrastructure investment gap is an old story. But one may ask what the ‘decades of capital expenditure neglect’ that tend to characterise the infrastructure sector in various countries suggest in terms of the sector’s outlook. And if this trend is likely to be reversed or not.

A Fallacy of Composition

This deserves further examination. Table 1 summarises the arguments typically advanced in the commercial brochures of dozens of listed infrastructure fund managers that we have reviewed (see list below).

Most of the arguments made in favour of listed infrastructure appear to be a fallacy of one type or another.

The fallacy arises thus: an argument is made about what infrastructure businesses are like (e.g. `Infrastructure firms are monopolies’) without necessarily fully qualifying this point (`In fact, when infrastructure firms are a monopoly, the tariffs they can charge are regulated.’), next an investment characteristic which is relevant from a portfolio stand point is inferred from the first point (`Monopoly rents create attractive risk/return profiles’).

In aggregate, this is a fallacy of composition i.e. inferring something about the whole which is only true about some of its parts. Private infrastructure investments may well have some of the characteristics implied by the infrastructure investment narrative, but that does not necessarily mean that collections of stocks that share an SIC code with these firms also do.

What #fake_infra really is

Beyond the often fallacious arguments extrapolated from the economics of private infrastructure firms, listed infrastructure products should be understood from a portfolio management perspective.

The arguments put forward in listed infrastructure products often combine the promise of alpha with that of accessing new betas.

Listed infrastructure funds are essentially active equity funds. The only difference with other active equity products is their focus on certain industrial sectors. One might say that they promise sector-specific alpha.

Of course, decades of academic research have shown that alpha is mostly an optical illusion: it is mostly betas in disguise that could be bought more cheaply than through active managers.

So listed infrastructure managers are just repackaging a product from the 1980s for the 2017 crowd. Active management increasingly lacks credibility, but a secular theme like infrastructure is more in tune with the spirit of the time.

Listed infrastructure ETFs, on the contrary, are a 21st century product: if the “listed infrastructure asset class” can improve portfolios diversification, lower portfolio volatility and has liability-hedging properties, could tracking an index of infrastructure stocks deliver new “betas”?

There are two major flaws in this argument:

First, the listed infrastructure indices (list in appendix) currently being tracked by ETFs are often built to include active views or using ad hoc weighing schemes (especially weight caps to avoid over-concentration in a few very large utilities). Hence, it is not necessarily clear what systematic risk exposures are being tracked through these indices.

Moreover, selecting stocks by industry would not deliver pure betas. We know from a solid body of academic knowledge that passive investing should be designed by focusing on well-defined, persistent remunerated risk factors.

It is not the case with listed infrastructure: systematic risk exposures are only implied from the investment narrative but never explicitly identified. Accessing risk factors through industrial sector filters is the wrong way to go about it.

The second flaw is of course that these listed infrastructure indices do not have any asset class or unique factor characteristics for an institutional investor, as we know from the peer-reviewed research described above.

This is why listed infrastructure is #fake_infra.

References

Bianchi, R. and T. Whittaker (2017). Is listed infrastructure an asset class? an asset pricing approach. EDHEC Business School Working Paper.